Chapter 13 - Measuring performance of economy PDF

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Measuring performance of economy...

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Chapter 13: Measuring performance of economy Article I.

Macroeconomic Objectives

Section I.1 Economic growth 1)

In a growing economy the total production increases from one year to another. If the population is growing but there is no economic growth then standard of living decrease.

Section I.2 Full employment 1)

Ideally all factors of production should be fully employed

2)

Economic growth does not guarantee full employment. E.g. production can be raised without employment, by utilising machines. However, economic growth is a necessary condition for the expansion of employment opportunities. (it is highly unlikely otherwise)

Section I.3 Price stability 1)

Individual prices should respond to changes in supply and demand.

2)

The process of increases in the general level of prices is called inflation.

a) The objective of price stability is to keep inflation as low as possible Disinflation is when prices increase but at a slower rate but deflation is when prices decrease. Fiscal policy is implemented by government only WHILE monetary policy implemented by the SARB (Reserve Bank)

Section I.4 Balance of payments (external stability) 1)

There is a high interdependence between different countries.

2)

To pay for imports the country has to earn the necessary foreign currency by exporting goods and services.

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a)

The objective of macro-economics is to have stability in the balance between imports and exports as well as the exchange rates

Section I.5 Equitable distribution of income 1)

It is a very subjective issue and often very emotional.

2)

Some believe that distribution of income should not be meddled with: a)

They believe that the unequal distribution is a means of stimulating saving and investments which will eventually also benefit the poor.

Article II. Measuring the level of economic activity: Gross Domestic product Section II.1 Introduction: 1)

Definition: The total value of all FINAL goods and services produced within the boundaries of a country in a particular period (usually one year)

2)

Usually calculated by Stats SA or SARB (Reserve bank) [usually accountants or bookkeepers of the whole economy]

3)

“Value”: a)

4)

“Final”: a)

5)

Use prices of various goods and services and not actually the number of items (how do you add apples and pears)

Any good or service that is purchased for reselling or processing is regarded as an intermediate good or service.

They need to make sure that they do not double count (otherwise they could overestimate or inflate the GDP)

Section II.2 Calculating GDP 1)

2)

Production method (Value added method) a)

After adding the full value of the first producer they only add the value added by each of the participants in the production process.

b)

Nowadays GDP measured from the production side is called Gross Value Added (GVA)

Expenditure method (final goods and services)

a)

The ultimate use of the product determines whether it is a final good or not

b)

If the good is not sold during the period in question it becomes part of the firm’s inventories which form part of investment in national accounts. Page 2 of 20

3)

c)

In this method you simply count the amount paid by the final consumer

d)

GDP= C+I+G+X-Z

i)

Sometimes, ‘I’ is called GFCF

ii)

When we use this method to calculate GDP, we need to count the amount of money spent by individuals (in any part of the world) on goods and services PRODUCED in south Africa. That is why we include: C,I,G, X (x=exports; people from outside SA spending money on goods in SA).

iii)

Since some goods we purchased are not produced in South Africa, we need to exclude them from GDP. That is why we subtract imports(Z)

Income method (incomes of the factors of production) a)

Consider only the incomes earned during the VARIOUS stages of production process by the owners of the factors of production. (check the profit the make upon the sale of good)

b)

Note: income earned = value added. This is because income is earned by producing (since producing means adding value to goods and services).

c)

For an economy as a whole, income can be increased only if production increases.

d)

Sales amount can be apportioned to the payment of FoPs (namely the primary inputs) and the secondary inputs (intermediate goods and services) These 3 methods measure the same phenomenon and therefore must yield the same answer (this improves accuracy). They yield the same answer because the value of the final goods and services must necessarily be made up of the successive values added in the different stages of production. (That is why, production method and expenditure method yield the same answer). Now for income method: income and production are the same side of the coin therefore they yield the same answer. Production results in income. Therefore total value of production will be equal to the total value of wages and salaries, interest and profit. The 3 methods measure the same thing, albeit at different points in the circular flow. (production requires FoPs reward for FoPs= income)

e)

Value of total sales= total primary income (rewards of Fops) + value of intermediate goods

i)

The total primary income includes profit since profit is reward of owner’s time and risk

ii)

Value of intermediate good is the price paid by the firm to the supplier to get the goods needed to be resold.

f) From the equation above we can manipulate it to get: Value of total sales – value of intermediate goods= total primary income

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i)

But the LHS represents the value added which is the value of the final good. Therefore we have proved that the value of the final good is equal to total income.

Section II.3 Components of GDP (a) Consumer spending 1)

Amount spent on goods and services by individuals during the year

2)

Also includes spending by charities

3)

Does not include investments (b) Government Spending

1)

Includes all spending on all goods and services (non-capital nature)

2)

Excludes: investment goods (e.g. buildings) and transfer payments (e.g. social welfare grants)

3)

We value government output at cost rather than market value because in instances, government goods are not sold

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4)

2 types of consumption: a) i)

b) i)

Individual consumption expenditure Spending on goods and services consumed by identifiable private individuals (e.g. health, education, welfare) Collective consumption expenditure Spending on public goods (like the defence, law and order, public admin)

(c) Investment spending (i) Change in inventories 1)

These are goods produced but not used for current consumption. They reflect goods produced during the periods that have not been sold, or goods produced in an earlier period but only sold during the current period.

2)

Reduction in inventories is a negative investment and vice versa

3)

Inventories are priced at market value and not cost (ii) Fixed Capital Formation

1)

Creation of new capital goods- durable goods which produce other goods(e.g. machines, buildings)

2)

Resale of existing capital goods is not counted as part of GDP, but commission paid will be included. (iii) Total investment spending= gross capital formation

1)

Replacement investment a)

2)

Investment required to maintain the existing level of capital stock

Net investments a)

Increases in total capital stock

b)

Net= Gross- replacement Investment

(d) Net exports 1)

Imports includes money spend when you are overseas while exports also includes amounts spent by tourists in SA (e) Other points

1)

GDP also includes output of foreign owned business that are LOCATED in SA following direct investment in SA economy

2)

Foreign direct investment is not included in the GDP calculations

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Section II.4 Financial flows 1)

Govt borrows finances when budget deficit (G>T)

2)

Govt lends when budget surplus (T>G)

3)

National savings = HH savings (households) + govt savings

4)

Country borrows from rest of world to pay for negative net exports (b) How investments is financed

1)

Y(income)= C+S+T

2)

Y (GDP)= C+I+G+X-M

3)

Set these equations to each other and make I the subject: I= S+ (T-G) +(Z-X)

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Section II.5 Further aspects of the definition of GDP 1)

2)

‘Within boundaries of country’domestic : a)

GDP is a geographic concept that includes all production within the geographic area of a country

b)

It does not matter who produces the goods or who owns the factors of production (It could be a german firm which produces and owns the factors of production). It is still counted as part of the GDP

c)

Nor does it matter to whom the goods are sold. They could be sold locally or exported.

For a period (usually one year) therefore it is a flow concept: a)

GDP is only concerned with NEW goods and services during a period. Therefore goods produced in previous period and sold in the current period is not considered.

b)

GDP is recorded when production has completed and NOT necessarily when the sale is made.

c)

The RESALE is not considered because nothing new is produced.

i) d) 3)

5)

Intermediate goods usually produce capital goods

Gross domestic income= gross domestic product: a)

4)

If an agent (such as a broker) is used for resale, then only their fees are added to GDP

Because production and income are the same side of the coin.

“gross”: a)

During period for which GDP is calculated, obsolescence and wear and tear cause capital equipment to depreciated. Provision is therefore made for such depreciation and this provision is subtracted from the value of output.

b)

The net amount is a more correct measure of economic performance, however in practice; gross measure is used over net amount since depreciation is difficult to measure.

GDP is usually released every quarter, therefore, you compare quarter 1 of 2014 with quarter 1 of 2015 since different goods and services are produced in each quarter.

Section II.6 Measurement at market prices, basic prices and factor cost (or income): The 3 methods to calculate GDP will only yield the same answer if the same set of prices are used but there are 3 sets of prices which can be used 1)

Market prices: a)

2)

This method is used when calculating GDP using the expenditure method

Basic prices; a)

Used when production (value added) method is used

b)

This is the price producers receive for goods and services Page 7 of 20

3)

4)

Factor cost: a)

Used when income method is used

b)

Prices received by the factors of production

The differences between the different prices is due to taxation and subsidies: a)

5)

When there are subsidies and taxes, the amount paid by the consumers differs from the cost of production and income earned by the various factors.

i)

E.g. prices paid by consumers for cigars are much higher than the income earned by all the producers combined.

ii)

When subsidies are placed then the amount paid by the consumers (market price) is lower than the factor price or the basic price

Types of taxes and subsidies: a)

Taxes on products

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i) b)

These are taxes payable per unit of some good or service (e.g. VAT, taxes on exports) Other taxes on production:

i)

These are taxes on production that are not linked to specific goods/services

ii)

E.g. payroll taxes, recurring taxes on land etc)

c)

Subsidies on products:

i) d)

Direct subsidies payable per unit (e.g. on exports to encourage exports) Other subsidies on production:

i) 6)

Subsidies that are not linked to specific goods (e.g. subsidies on employment, passenger transport)

Identities: a)

GDP (at market prices) - taxes on products + subsidies on product= GDP at basic prices

b)

GDP (at basic prices) - other taxes on production + other subsidies on production= GDP at factor cost

Section II.7 Measurement at current prices and at constant prices: 1)

Nominal or current prices a)

2)

Constant (real) prices: a)

3)

Ruling prices used to calculate GDP

Since we compare GDP from year to year, we have to account for inflation. Therefore we choose a base year, and calculate GDP at the ruling prices of the base year. This way, we can see the intrinsic growth of the economy.

The difference in increase of GDP using the nominal and the real prices method is known as the inflation.

Section II.8 GDP Gap 1)

Actual GDP (represented as Y) is how much the economy actually produces. Potential GDP (Y*) is what the economy would produce if all resources were fully employed at sustainable levels of utilisation

2)

GDP Gap= Y-Y*= actual-potential

3)

Note: actual GDp can be greater than Y*

4)

IF Y>Y*: a)

5)

This is positive GDP gap- called inflationary gap

If YGDE then it follows that exports are greater than imports (X>Z) and this applies also for the opposite situation.

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Article IV. Measuring employment and unemployment 1)

Definition of unemployed: a) i) b) i)

Strict definition A person has to have taken steps recently to find work Expanded definition: The person only has to have the mere desire to find employment

2)

In the apartheid era there was a tendency to under-estimate unemployment among black workers. The strict definition is the convention to be used when measuring unemployment.

3)

As a student, you cannot be considered to be unemployed since you are not part of the labour force through your own choice

4)

The informal sector:

5)

a)

The formal sector is defined as people who are employed full-time capacity in the modern or formal sector of the economy.

b)

The informal sector (aka shadow economy, unrecorded economy, underground economy, hidden economy).

c)

Reasons why people engage in the informal sector:

i)

They cannot find employment in the formal sector

ii)

They are engaged in illegal activities

iii)

They do not want to pay taxes

Economists regard the growth of the informal sector as a symptom of a stagnating or declining economy and they believe that stimulating formal sector activity will overcome this stagnation

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Article V.

Measuring prices: Consumer price index

Section V.1 Prices and purchasing power 1)

As prices of goods increases but the income remains the same then purchasing power (real value) of income decreases.

Section V.2 Consumer price index (CPI) 1)

It is an index of the prices of a representative ‘basket’ of consumer goods and services. Therefore CPI represents the cost of a typical or average SA household. (b) Selecting goods and services to be included and the assignment of the weight to each good to indicate its relative importance in the basket.

1)

StatsSA does a survey to determine which are the important items and the weight is determined based on the average consumer budget

2)

It is done every few years and the fact that it is not done more regularly is not really a problem since the pattern of household spending does not change significantly from year to year.

(c) They choose a base period to calculate the CPI (d) Decides on a formula for calculating CPI 1)

How to construct a price index a)

(New price/ Old price ) *100  in this way, you set the old price to 100 and you find the relative cost of the good in the next year in terms of the old price.

2)

The overall increase in cost of living is closer to the increase in price in the good with the more weight

3)

Index numbers a)

An index number expresses the value of some series in any given period as a percentage of its value in the base period.

b)

Specific index

i) c) i)

Expresses relative changes General or composite index When they combine different series into an average. Each series has to be weighted according to its relative importance… such is the CPI

Section V.3 GDP deflator 1)

A differential change in nominal and real GDP over some time period implies that prices over that period must have changed

2)

Implicit deflator= ((GDP at current prices)/(GDP at base-period prices) ) *100 a)

Implicit deflator -100= price increase Page 13 of 20

Article VI. Measuring links with the rest of the world: the balance of payments  4th macroeconomic objective 1)

Each country keeps a record of its transactions with the rest of the world. This accounting record is known as the balance of payment

2)

Consists primarily of 2 major accounts: current account and financial account

3)

Changes in purchasing power

4)

a)

If R100 was enough to buy a certain basket of goods in 2005 but that same basket costs R163.10 in 2011; therefore R100 can only buy a fraction of the basket in 2011. The old CPI/The new CPI = the new purchasing power of R1

b)

The real value of money is obtained by dividing nominal amount by the price level.

All(not just government transactions but also transactions by individuals, firms etc) transactions with the rest of the world are recorded in the balance of payments a)

5)

6)

Exports, imports, primary income receipts and payments are recorded in the current account a)

If there is a surplus in the current account then exports>imports. Vice versa for deficit